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New FINRA Report Emphasizes that Firms Should do More to Manage and Mitgate Conflicts of Interest

Monday, November 18, 2013

In a the new FINRA “Report on Conflicts of Interest”, focuses on ways that broker-dealers can do more to manage and mitigate conflicts of interest in their business. There cannot be talk of a conflict of interest without starting first with the best interest of the client. This report states “an effective practice is to add to a firm’s code of conduct, or other appropriate documents, a best-interest-of-the-customer standard… under this Code standard, a broker should make only those recommendations that are consistent with the customer’s best interests.” This is also reiterated by SEC commission chair Mary Jo White. One concern, she said in a recent article, was establishing some “clear guideposts” around what constituted a conflict of interest for brokers if they were acting under a fiduciary standard. “Just because there are commissions [being paid] does not mean that there are conflicts of interest or that it is a violation of the fiduciary duty,” White said.

Currently brokers are held only to a rules-based suitability standard. The fiduciary standard of care is widely viewed as more stringent than the suitability standard. Some are concerned it is impossible to prove which product is “best” for a client. However, a fiduciary standard does NOT require that a recommended product be the “best” product. Instead, it prescribes a “prudent process” which, if followed, can protect fiduciaries against future claims that some product was not the “best” for a given client in a given situation. In other words, fiduciaries who follow a “prudent process” can actually be wrong about product selection and not be liable for recommending a product that may not have been the “best” in hindsight. As such, even if the SEC does not impose such a fiduciary standard-of-care on brokers in the near term, the days of brokers representing the products from some limited number of insurers while implying they are representing the best interest of the client are likely numbered.

The FINRA reports goes on to state, “one of the fundamental potential conflicts in the securities industry occurs in the distribution channel: the sale of products or services to generate revenue or profit without proper regard to suitability standards. This conflict affects both the registered representative and the firm. This conflict is magnified when a firm favors proprietary products or engages in revenue-sharing with third parties to the detriment of customer interests.”  The report highlighted the need for “necessary diligence and independent judgment to protect their customers’ interest…without pressure to favor proprietary products or products for which the firm has revenue-sharing arrangements.”

The report expresses concerns about the increased sale of complex products to retail investors who may struggle to understand the features, risks and conflicts associated with these products. Firms evaluate registered representatives’ ability to understand a product, provide training where it is necessary and limit registered representatives’ access to products for which they cannot 1) demonstrate sufficient understanding to perform a suitability analysis and 2) effectively explain a product and its risks to customers.

Brad Bennett, FINRA’s Executive Vice President was quoted in a recent article, “If you see products being sold by people who don't understand them to people who don't understand them, that's a supervision and suitability problem,” Mr. Bennett said. “The cost of doing business incorrectly has to be greater than the cost of doing business correctly, or you give a competitive advantage to a non-compliant firm.”

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